FINANCIAL RISK
Financial risk is the type of specific risk that encompasses the
many types of risk related to a company’s capital structure,
financing and the finance industry. These include risk involving
financial transactions, such as company loans and exposure to
loan default.
TYPES OF FINANCIAL RISKS:
Financial risk is one of the high-priority risk types for every
business. Financial risk is caused due to market movements and
market movements can include a host of factors. Based on this,
financial risk can be classified into various types such as
Market Risk,
Credit Risk,
Liquidity Risk,
Operational Risk
MARKET RISK
Market risk, also called "systematic risk," cannot be eliminated
through diversification, though it can be hedged in other ways.
Sources of market risk include recessions, political turmoil,
changes in interest rates, natural disasters and terrorist attacks.
Systematic, or market risk, tends to influence the entire market
at the same time.
e.g corona virus
The most common types of market risks include interest rate
risk, equity risk, currency risk and commodity risk.
Interest rate risk covers the volatility that may
accompany interest rate fluctuations due to fundamental
factors, such as central bank announcements related to
changes in monetary policy. This risk is most relevant to
investments in fixed-income securities, such as bonds.
Equity risk is the risk involved in the changing prices of
stock investments,
Commodity risk covers the changing prices of
commodities such as crude oil and corn.
Currency risk, or exchange-rate risk, arises from the change
in the price of one currency in relation to another. Investors
or firms holding assets in another country are subject to
currency risk.
Credit Risk
Credit Risk refers to the probability of a loss owing to the
failure of the borrower fails to repay the loan or meet debt
obligations. In other words, it refers to the possibility that the
lender or creditor may not receive the principal and interest
component of the debt resulting in interrupted cash flow and
increased cost of collection.
Types of Credit Risk
It can be broadly categorized into three types – credit default
risk, concentration risk, and country risk. Now, let us have a
look at each of them separately:
#1 – Credit Default Risk
Credit default risk covers the type of loss that is incurred by the
lender either when the borrower is unable to repay the amount in
full or when the borrower is already 90 days past the due date of
the debt repayment. This type of credit risk influences almost all
financial transactions that are based on credit like
securities, bonds, loans, or derivatives. Credit default risk is the
reason why all the banks perform a thorough credit background
of its prospective customers before approving them any credit
cards or personal loans.
#2 – Concentration Risk
Concentration risk is the type of risk that arises out of significant
exposure to any individual or group because any adverse
occurrence will have the potential to inflict large losses on the
core operations of a bank. The concentration risk is usually
associated with significant exposure to a single company or
industry or individual.
#3 – Country Risk
Country risk is the type of risk that is seen when a sovereign
state halts the payments for foreign currency obligations
overnight, which results in default. Country risk is mainly
influenced by a country’s macroeconomic performance, while
the political stability of a country also plays a pivotal role.
Country risk is also known as sovereign risk.
Liquidity risk
Liquidity risk is the risk that pertains to the conversion of assets,
securities, or bonds into cash without affecting their market
price due to unfavorable economic conditions.
Funding Liquidity Risk
Funding liquidity risk is the risk of not being able to meet
one’s financial obligations due to a lack of liquid funds. The
operating cash flows may be low for a company, resulting in the
risk of non-fulfillment of its short-term payments. This may
result in damage of goodwill, frequent shortages of raw
materials and inputs due to supply cuts leading to loss of
production, customer shifts, etc.
Market Liquidity Risk
Market liquidity risk means the risk where disposal of the
securities in the market is difficult. And disposal in such a
situation may entail without incurring a substantial loss in value.
This may be due to situations like unstable economic conditions,
heavy price fluctuations, etc. Such risk causes the stock prices of
a company to fall, leading to a selling frenzy. High supply with
no matching demand further leads to a fall in the prices of the
stock.
Operational risk
Operational risk summarizes the chances and uncertainties a
company faces in the course of conducting its daily business
activities, procedures, and systems. Operational risk is heavily
dependent on the human factor: mistakes or failures due to
actions or decisions made by a company's employees
Types of Operational Risks
The following are types of operational risks
#1 – Human Error
We can also refer to this as a fat finger input error. This type of
error is the most common and most significant risk to the
organization or individual. It may also relate to the skill issue of
the processor. This type of error evolves when incorrect input is
because of human error. The reasons for incorrect input may be
multiple, including incomplete information, incomplete
understanding, insufficient knowledge, inconsistent processing,
genuine input error, or more. However, processing of such an
error may affect the output seriously and may also lead to a loss.
#2 – Technical Error
This includes system glitches. Even though everything is
perfect, there are sometimes system issues like a slowdown,
connectivity, system crashes, incorrect calculation by
application, or a new missing bridge. Sometimes, the output
received may be off from the actual expected result, but because
of unknown technical defects, it may be challenging to catch.
#3 – Gap in Flow
Sometimes, information is missing from the source itself
because of data lag or restrictions. In such cases, the output gets
affected. The required production varies from that desired and
may put the process at risk.
#4 – Uncontrollable Events
These include effects from an external environment like political
scenarios, weather changes, syndromes affecting living beings,
outdated technology, etc. which affect the performance and
quality of processors and hence puts the output at risk.
#5 – Intentional Frauds
There have been cases where intentional conflict of interests has
arisen, resulting in an illegal profit to trade executors. Most of
the organizations have a clause in their policies which the
employees have to abide by, for fighting against conflict of
interests and fraudulent practices, failing which they meet with
extreme consequences. However, if such an event occurs, the
firm has to bear monetary and defame losses, which are
sometimes irrecoverable.
